Hedge fund snake oil for Puerto Rico

The prospects for an early resolution to Puerto Rico’s debt crisis do not appear to be good. For judging by this week’s report commissioned by hedge fund owners of Puerto Rican bonds, the hedge funds seem to be arguing that Puerto Rico does not have a government debt problem. Indeed, they appear to be arguing that all that Puerto Rico needs to do is to fully implement the budget austerity and structural reform measures suggested by the recent Krueger report (commissioned by the Puerto Rican government) and all would be well on the island.

{mosads}The hedge fund report, commissioned from a group of former International Monetary Fund (IMF) economists and entitled with the misnomer “For Puerto Rico, There is a Better Way,” is seriously flawed. It bases its conclusions on its idiosyncratic interpretation of the Krueger report. It does so by asserting that if that report’s recommendations of severe budget austerity and structural reform were fully implemented, Puerto Rico’s government deficit problem would disappear and its government debt problem would be resolved.

Yet somehow the hedge fund report overlooks the fact that the Krueger report found that even if all of its recommendations would be strictly implemented, Puerto Rico’s government would still have a very large unfunded financing gap. Indeed, the Krueger report estimated that over the next 10 years, even if all of its recommendations were to be implemented to the letter, Puerto Rico’s financing gap would amount to around 30 percent of the government’s debt servicing obligations. That finding led the Krueger report to explicitly state that debt restructuring would have to be part of the solution to the island’s government debt problem.

An equally seriously flaw of the new hedge fund report is its assertion that large-scale budget austerity is consistent with economic growth. In making this assertion, the report purports to rely on IMF research on earlier country experience with austerity. However, the report fails to make the crucial distinction between countries that applied budget austerity with floating exchange rates and with monetary policy independence in contrast to those that tried to do so in a monetary union or in a fixed exchange rate system. In the later case, the country was denied the use of an independent exchange rate or interest rate policy that could be used to offset the negative effects of radical budget tightening on aggregate demand.

One has to wonder where the authors of the hedge fund report were during the recent European sovereign debt crisis in Greece, Ireland, Portugal and Spain. Or where might they have been during Argentina’s experiment with its Convertibility Plan in the late 1990s or during Latvia’s experiment some eight years ago with severe budget tightening in a fixed exchange rate system? For in each of those cases, severe budget tightening in a fixed exchange rate system led to a plunge in output and to a rise in unemployment of epic proportions that had no precedent in the post-war period.

The sad reality is that Puerto Rico finds itself stuck in a monetary union with the United States. As such, Puerto Rico has no ability to depreciate the U.S. dollar to its advantage as an offset to the proposed budget tightening. Indeed, over the past year, Puerto Rico has seen the U.S. dollar appreciating on an effective basis by over 20 percent when it so desperately needs a weaker currency.

Not having its own currency, there is every reason to expect that if Puerto Rico went the draconian budget austerity route proposed by the hedge funds, it would follow those countries that tried large-scale budget austerity in a fixed exchange rate system into many years of economic misery. It is not clear that such a path would serve Puerto Rico well. It is also not clear whether it would put it in a better position to service its government debt. For which reason, Puerto Rico would do well to ignore the hedge fund’s report and to follow instead the Krueger report’s suggestion that it presses for a reasonable amount of debt relief from its bondholders as an important part of an adjustment program to restore balance to its public finances.

Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.